EC365 Theory of Monopoly and Regulation Topic 9: Regulation and liberalisation

1. EC365 Theory of Monopoly and RegulationTopic 9: Regulation and liberalisation 2013-14, Spring Term Dr Helen Weeds

2. Lecture outline • Liberalisation: introducing competition • Industry structure and natural monopoly • Vertical integration or separation? • Barriers to entry • Access pricing • Liberalisation in the UK

3. Liberalisation: introducing competition • It may be feasible & desirable to introduce competition into some parts of the industry • note: cross-subsidies will become unsustainable • Where can this be done? • look at vertical structure • identify natural monopoly • Achieving effective competition • industry structure • liberalisation and entry • access pricing

4. Where does natural monopoly arise? • Transportation networks (pipes, wires, tracks) • Expensive to duplicate • economies of scale • economies of density • Potentially competitive areas • products / services provided over networks • if can access transportation on reasonable terms, competitive supply is possible

5. Telecommunications • Access network: local loop and local exchanges • Backhaul: connects local exchange to long-distance network • Core network: long-distance conveyance • economies of scale are exhausted • Services: voice calls, data, broadband, video

6. Upstream gas supply Long-distance transmission Local distribution  Gas supply • Offshore gas supply • already competitive • Long-distance transmission (high pressure) • Local distribution (low pressure) • Supply to households • sourcing gas • metering, billing, customer services

7. Generation Long-distance transmission Local distribution  Electricity supply • Electricity generation • from coal, gas, oil, nuclear, renewables, imports • Long-distance transmission (high voltage) • Local distribution (lower voltage) • Supply to households • sourcing power • metering, billing, customer services

8.  Rolling stock  Tracks & stations  Maintenance Train services Railways • Train services require 2 main inputs • track infrastructure & stations • rolling stock: engines & carriages

9. Vertical structure (1): integration • Monopoly and potentially competitive activities not always easily defined • Retain benefits of vertical integration • economies of scope (e.g. coordination between stages); vertical externalities; investment risks & hold-up • Allow competition where feasible and desirable • entrants compete with incumbent in some areas • Regulate access to monopoly elements • incentive to discriminate • price and non-price aspects • E.g. telecoms, early gas industry (1986-97)

10. Liberalisation with vertical integration

11. Vertical structure (2): separation • Separate natural monopoly from potentially competitive activities • regulate natural monopoly elements only • no incentive to discriminate between users (unintegrated) • Introduce competition into other areas • regulation is unnecessary (eventually) • Possible loss of efficiencies from vertical integration • coordination e.g. electricity generation and supply • investment risks & hold-up, etc. • E.g. electricity, railways, gas industry after 1997

12. Liberalisation with vertical separation

13. Barriers to entry • Suppose monopoly sector is liberalised • incumbent has very high market share initially • Despite removal of legal barriers, entry may be difficult • post-entry competition and sunk entry costs • excess entry and entry restrictions • retail price controls • customer inertia • exclusionary / predatory behaviour • Additional issue arises under vertical integration • incumbent control of key inputs

14. Sunk entry costs • Suppose [similar to entry game in topic 5] • Bertrand competition post-entry • entrant’s operating cost no lower than incumbent’s • sunk entry cost • Outcome • post-entry competition drives price down to cost • potential entrant will not enter • note: entry would be particularly beneficial here! • Entry assistance: could subsidise entry • but benefits are difficult to quantify • perverse incentive effect

15. Excess entry and entry restrictions • Possibility that “too much” entry occurs following liberalisation • Temporary duopoly policy (e.g. telecoms 1984-91) • argument that first entrant needs protection from further entry, to get established • not coherent: if 3rd player renders 2nd player unprofitable, why would 3rd enter (unless it is more efficient)? • Restricting no. of competitors likely to be detrimental • weakens selection effect of competition • limits pressure to reduce costs and prices, and to innovate • may facilitate collusion

16. Retail price controls • Should retail price controls be removed? • early on, competition may not constrain prices (much) • desire to retain controls until competition has developed • but strict price controls limit entrants’ profits too • may prevent competition from developing • thus, trade-off between consumer welfare in S-R and L-R • Where regulation is maintained, tariff rebalancing may be required to reflect costs • entrants will target areas where P > cost • productive inefficiency: higher cost entry may occur • no benefit from competition to subsidised customers • cream-skimming may undermine viability

17. Customer inertia • Competition is effective only if consumers respond to competitive offers by switching supplier • access to information about competitor services • price, quality • switching costs • e.g. number portability • cost asymmetries between incumbents and entrants • e.g. carrier pre-selection to direct (some or all) calls to competing operator • Positive externality from switching: competition benefits allconsumers, not just those that switch

18. Exclusionary behaviour • Incumbent may try to exclude competition through targeted price cuts • prices below cost exclude efficient entry • also encourage excessive consumption • Possible regulatory measures • prohibit below-cost pricing • esp. with price cap, where other prices can then rise • requires detailed cost measurement & allocation • non-discriminatory pricing and price publication • Antitrust policy: exclusionary behaviour under Art. 102 / CA98 monopolisation provisions

19. Competition policy vs. regulation

20. Access regulation under vertical integration • Vertically integrated structure with • monopoly network (upstream) • potentially competitive retail market (downstream) • Retail market competitors require access to incumbent’s network infrastructure • monopoly problem: access price needs to be regulated • incumbent must cover fixed network costs • competitive entry may undermine cost recovery, unless incumbent gains adequate return • incumbent has strong incentive to discriminate • competition with incumbent’s own retail business

21. Access pricing • Suppose network has fixed cost F and marginal cost ca • Asymmetry between incumbent’s retail business and its competitors • incumbent faces marginal cost of access, ca • note: transfer prices irrelevant • competitors face (regulated) access price, a • suggests setting a = ca to set level playing field • but this may not be optimal …

22. Access pricing at marginal cost • 2 problems • Incumbent must recover fixed cost F • F is recouped from mark-up on retail prices • if a = cN, retail market competition will eliminate mark-up • Undermines recovery of fixed cost F • thus requires a > cN • Undesirable to encourage inefficient entry • want entry by firms at least as efficient as incumbent • but not those with (retail) costs higher than incumbent’s

23. Efficient component pricing rule (ECPR) • Baumol (1983) & Willig (1979) • incumbent supplies network access to retail competitor(s) • single retail product, with regulated retail price • access is rivalrous • giving access to competitor  less available for incumbent • Costs • network: fixed cost F, marginal cost cN • retail market: incumbent has marginal cost cR • Prices • retail: reg’d price P; margin = P – (cN+ cR) just covers F • wholesale: how should access price a be set?

24. ECPR or “retail minus” • Efficient access price a equals • direct MC of providing access, cN • plus the incumbent’s opportunity cost of supplying access • this is the foregone retail margin, P – (cN + cR) • Result: “margin rule” (or “retail minus”) • access price a = cN + P – (cN + cR) = P – cR • i.e. retail price minus incumbent’s retail MC • i.e., retail margin (P – a) should equal retail MC, cR • basis of “margin squeeze” test • E.g. Suppose retail price P = £100 and cR = £10 • then a = £100 – £10 = £90

25. Advantages of ECPR • Productive efficiency: only efficient entry occurs (i.e. competitors with retail cost cR) • e.g. low-cost entrant with retail cost cL < cR • total cost per unit = a + cL = P – cR+ cL< P • e.g. high-cost entrant with retail cost cH > cR • total cost per unit = a + cH = P – cR + cH > P • Revenue neutrality • entry does not undermine network cost recovery • Implementation relatively straightforward • requires info about retail costs, but not demand etc.

26. Criticisms of ECPR • Does not eliminate excess profit downstream • compensation for lost retail margin, may be above cost • Simplicity results from strong assumptions • displacement of incumbent’s product may not be 1-for-1 • entrant may offer new / differentiated product • entrant may be able to bypass the network, albeit with less efficient technologies • can extend ECPR to differentiated products a = cN +  (P – cN – cR) where  = displacement ratio: no. of lost incumbent sales for each unit of access supplied (typically < 1)

27. What if retail prices are not regulated? • Suppose • retail price P is unregulated • regulator sets access price a • Firm sets P to maximise profit • P(a) > Preg: higher profit from access reduces incentive to compete at retail level • Regulator sets access charge to • allow efficient entry (as in ECPR) • stimulate retail competition to reduce P towards cost: lowersa compared with ECPR

28. Other access issues • Non-price aspects • quality of inputs supplied to competitors • speed of delivery • maintenance etc. • Generally harder to specify and monitor • Possible approach: “transactional equivalence” • Incumbent should offer same wholesale products and service standards to rivals as to its own downstream arm • Principle behind Ofcom’s Strategic Review of Telecoms (2004-05) and BT’s internal separation of Openreach

29. Liberalisation in the UK: telecoms • Vertically integrated at privatisation (1984): BT • duopoly policy until 1991 • BT had monopoly over supply to residential customers • competition for business customers from Mercury Communications (part of Cable & Wireless) • Liberalisation • 1991: cable firms permitted to compete for household mrkt • 1998: competing call services without own access lines • indirect access, call pre-selection (both use BT’s access line) • 2000: local loop unbundling allows rival broadband firms • 2004-05: Ofcom’s Strategic Review of Telecoms • internal separation of Openreach (access & backhaul networks)

30. Gas supply • Vertically integrated at privatisation (1986): British Gas • monopoly over supply to small customers • possibility of competition to large customers • Initially, little competing supply • price discrimination by BG • difficulty obtaining offshore gas • Later: vertical separation of pipes and supply (1997) • demerger into BG (now National Grid) and Centrica • Liberalisation • phased introduction of competition to smaller customers (completed 1998; price controls removed 2002)

31. Electricity supply (England & Wales) • Vertically separated at privatisation (1990-91) • generation • National Power (50% of capacity); PowerGen (33%) • some nuclear plant later privatised as British Energy (1996) • transmission (& Pool operation): National Grid Company • distribution and supply: 12 Regional Electricity Companies • Since privatisation • generation has become less concentrated • re-integration between generation and retail supply • separation of distribution (wires) and retail supply • competitive supply: completed 1999; price controls removed 2002

32. Railways • Vertically separated at privatisation (1996) • National rail network (track, signalling, bridges, tunnels, stations & depots): Railtrack / Network Rail (from 2002) • Train operating companies: regional franchises (passenger and freight) • Rolling stock companies (3): lease carriages etc. to TOCs • Maintenance: many companies • Initial plan to allow competing services on the same tracks was dropped • Competition for franchises (7-14 years duration)